Mortgage crisis shows why financial regulation is needed

WASHINGTON — Why didn't Wall Street firms tell potential investors that the bonds they were selling them were rotten? Why did their business partners, including subprime mortgage lenders, ignore glaring evidence that borrowers weren't qualified and give loans to virtually anyone with a heartbeat?

The answer is simple: Because they could.

In many cases, no law or regulation prohibited these firms from doing what they did. In others, former regulations that might have impeded them had been rolled back.

After 30 years of a national political culture that damned government regulation and celebrated unfettered markets, the lions of Wall Street were free to practice the social Darwinism at the heart of their world — survival of the fittest, and the winner feasts on the spoils. Smaller players down the financial food chain played by the same ethics-free ethos.

That's the back story to the U.S. financial crisis. At every turn where regulation was missing in action, the actors did the wrong thing, all along the long, interconnected trail of transactions that make up mortgage finance.

"This crisis started one household at a time. As much as everyone wants to talk about derivatives and shadow markets and rating agencies, it started as one lousy mortgage sold to one family, repeated millions of times," said Elizabeth Warren, a Harvard University business law professor whose thinking has helped shape the regulatory overhaul efforts now under way in Congress.

At the front of the chain were homeowners who took out loans with no documentation or little verification of income, bidding for more home than they could afford and betting that prices would keep rising forever. Mortgage brokers who originated their loans often received legal kickbacks from conscience-free lenders if they got borrowers into creative loans with high and adjusting interest rates.

The mortgage brokers churned volume for big subprime lenders such as New Century Financial and Ameriquest Financial, both now defunct. They exploited a regulatory gap to become nonbank lenders, which were regulated only on the state level, and spottily at that.

To address the "liar's loans" and mortgage-broker trickery, Congress is pushing to create a Consumer Financial Protection Agency. It would regulate consumer credit products such as mortgages, credit cards and payday loans.

The agency would force lenders to offer products with simpler terms and greater disclosure. It would regulate consumer credit in the interest of borrowers, not lenders. This agency, Warren's brainchild, would address directly the weakened lending standards that Wall Street exploited, and which led to the financial crisis.

"This is trying to move that to a world where there is light. One of the necessary ingredients is light, that people can track the terms of a deal, make comparisons among products, and not take on crazy risks," she said. "We've learned the consequence of too much risk aggregated in the system, it's brought us to our knees. The CFPA isn't about playing the Nanny State; it's giving customers the tools to protect themselves."

Bad lending practices wouldn't have done so much damage, especially in places such as Florida and California, if they hadn't happened on such a large scale thanks to Goldman Sachs Group and its competitors.

Investment banks such as Goldman took possession of the poor-quality mortgages and then, working in consultation with credit-rating agencies, packaged them into a highly rated securities backed by pools of mortgages for sale to big institutional investors.

Many institutional investors — state pension funds and charitable endowments, among others — were required to purchase only the highest-rated securities. So it was imperative for the rating agencies to help their deep-pocketed investment bank clients attain top ratings for the mortgage-backed securities the banks issued.

As recent history shows, top-rated securities quickly became junk as the housing market tanked and homeowners couldn't make their mortgage payments. The reputations of Goldman, its competitors, and rating agencies such as Moody's Investors Service, fell along with home prices.

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Because their sole mission is to provide investors with reliable signals about the risk they're assuming, the rating agencies' failure to score the securities accurately is particularly damning. They were supposed to keep investors in mind, even as they were paid to rate the bonds and mortgage securities by their issuers, such as Goldman.

Congress is now addressing the role of investment banks and rating agencies. Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, on Oct. 27 introduced legislation that would force investment banks to retain 10 percent of whatever mortgage-backed securities they sell to investors. The banks thus would be forced to eat their own cooking.

Frank's legislation also would require about 120 banks with assets valued above $10 billion to share the cost of closing down one of their brethren if necessary. That means that the cost of any future crisis would be borne by Goldman and other big banks, not taxpayers.

Separate legislation revamping the regulation of credit rating agencies seeks to make it much harder for Goldman or any other "investment" bank to influence securities' ratings.

During the housing boom, investment banks could withhold a preliminary rating from say, Moody's, while seeking a better rating from Standard & Poor's or Fitch Ratings. A bill passed Oct. 28 by Frank's committee would force Goldman or one of its rivals to publish any preliminary rating to prevent shopping around for better ratings.

Robert Pozen, the chairman of MFS Investment Management, a large fund manager, and a former teacher at Harvard's business and law schools, thinks that requirement falls short.

"I think that's a step in the right direction, but the reality is more of this is done before you get to the preliminary rating. Most of it is done where you have an information conversation with someone and that's worked out," Pozen said. "I think once you get to the preliminary rating stage, it's pretty far along. Most of the (questionable) stuff is done on a handshake pretty early in the process."

Pozen favors having regulators appoint a consultant to assign rating agencies randomly to issuers of securities.

One key component of the crisis isn't being addressed directly.

The financial crisis was made possible in part by the late 1999 decision by the Clinton administration and a Republican-led Congress to roll back the Depression-era Glass-Steagall Act.

This 1933 law prevented deposit-taking commercial banks from engaging in the securities business. The rollback allowed Bank of America, Citigroup and other large conventional banks to create massive and lucrative trading operations. They got deeply involved in complex financial instruments such as credit-default swaps that eventually threatened their core businesses and the global financial system.

Former Federal Reserve Chairman Paul Volcker, who's advising the Obama administration, has called for a restoration of the Glass-Steagall's separation of commercial banks from more speculative investment banks.

"There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships -- individuals, businesses, investment management clients seeking credit, underwriting and unbiased advisory services," Volcker wrote in September congressional testimony. "I also think we have learned enough about the challenges and distractions for management posed by the risks and complexities of highly diversified activities."

Volcker's calls have gone unheeded, even by Obama, but Volcker recently picked up support from former Citigroup Chief Executive John Reed. In a letter to the New York Times, Reed supported Volcker's call to restore the Glass-Steagall protections.